It seems that at least once a week lately, I'm forced to change ships midstream because the pace of this market's decline is surpassing even my most pessimistic assumptions from just a few weeks ago. Myriad factors are arrayed against the markets and the scandal in the Financials (thanks to C and JPM being shown to have really been in bed with Enron) that surfaced yesterday is just the latest iceberg to hit the Titanic. Needless to say, that Chinese proverb/curse about living in interesting times has been ratcheted up a few notches.
I had a completely different article all ready to go for today, which I think many of you will find quite interesting, but it will have to wait until next week. It centers on the issue of who stands behind the options/LEAPS that we buy if we really have a substantial market decline (as if we aren't in the middle of one already!). Somebody sold those options that we bought, and the question (How do we know there will be a market for that LEAP when we want to sell it for a profit?) is one we should all ask at some point in our option trading careers. Suffice to say, the answer is rather interesting, especially as it pertains to index LEAPS, but as I said above, we have bigger fish to fry here tonight.
Over the past few days, I've had several readers who have requested some detailed information on index LEAPS and where we might look for longer-term trades with the major indices having fallen so far, so fast. We've talked about it numerous times in the LEAPS column, that the ideal time to purchase LEAP Calls is when the VIX is at an extreme high. Well, with the VIX closing at an all-time high of 50.48 yesterday, it certainly seems like there could be some truly attractive LEAP Call trades to take when this crazy market stops falling.
Like all of you, I'd give my eye teeth to know at what level on any major index this selling would come to an end, even if that end is just temporary. Unfortunately, my crystal ball is currently non-functional, but the last reading I got said that a DOW in the 7300-7400 area and the S&P 500 in the vicinity of 730-740 looked like a high-odds bet. Unfortunately we seem to have a ways to go before reaching those extreme levels. But trying to pick what those support levels that hold will be is an exercise in futility so long as there are no sustained signs of strength.
Rather than spend our time here trying to put together a LEAPS play on the indices that may or may not set up for us, I thought it would be instructive to review which indices have LEAPS available, what their advantages and disadvantages are and how we might best use them to our financial advantage.
S&P 500 - The granddaddy of the indices, the S&P 500 or SPX is the index of choice for the professionals and as such is only for those with deep financial pockets when considering a viable LEAPS trade. When buying a LEAP call, we want to purchase the LEAP out of the money, but not so far that we have to have a huge move before seeing our LEAP begin to appreciate. I'm writing this on Tuesday night, and the SPX closed just south of 800 for the first time in over 5 years. But lets assume for the sake of argument that this is the bottom and we want to buy a LEAP call at current levels. What strike would we pick and how far out in time?
Even that question is a bit convoluted, as the expiration months on index LEAPS are different than for individual equities. While equity LEAPS all have an expiration in January of the specified year (2003, 2004 or 2005), index LEAPS adhere to the following schedule:
Obviously, the expiration month you choose will depend on the timeframe over which you expect the rebound to take place. Given the fact that most pundits are now admitting the 2002 recovery is DOA and some are calling into question the probability of a 2003 recovery, I would personally opt for as much time as possible and go for the June 2004 LEAPS. Another part of my rationale is that I know from my experience with equity LEAPS, that the further out in time I go, the less effect volatility has on the option premium. With volatility as measured by the VIX currently sky-high, going as far out in time as possible helps to insulate us from the volatility factor.
If we are looking for a shorter-term trade (say on the order of 2-5 months), then we'll want to pick a strike that is closer to the money, perhaps the 900 strike. On the other hand, if we're expecting that this bottom will be THE bottom and want to hold for the duration, then we might feel comfortable with a strike further out of the money, maybe even the 1050 strike.
So let's look at some prices to see what the price of admission is. The JUN-04 900 Call is currently trading for a cool $6740, while the JUN-04 1050 Call is being offered at a mere $2930. While that latter option may seem like a downright bargain, note that it would require a 125 point move in the SPX (ignoring the effects of volatility and time decay) to give us a double on the trade. [I'm making this estimate based on the fact that the 925 strike is currently trading for $5930, roughly double the current value of the 1050 strike.] Making a similar assessment of the 900 LEAP Call shows that the same 125 point move in the index would yield closer to a 90% return. So if holding for the big move over a long period of time (9 months or more), we might do better by selecting the strike further out of the money.
However, if we are looking for a smaller move in the index, we would do well to select the strike closer to the money, so we don't have to wait for an extreme move before seeing our LEAP begin to appreciate. Those strikes that are FAR out of the money will actually start to see a fair amount of premium decay as volatility decays back nearer to its normal range, and this can offset a large portion of the expected premium increase as the index moves in our favor.
Here's an exercise that you can all do at home to evaluate the risks and rewards of picking different strikes. Go to the CBOE site and pull up a complete option chain (including LEAPS) for the SPX and look at the different prices for different strikes. Then you can make assumptions for how far you expect the index to move and then come up with a reasonable future estimate of the price of that option after the move has occurred.
For instance, if the JUN-04 800 Call currently costs $11,300, and the JUN-04 700 call currently costs $16,750, I can conclude that an at the money JUN-04 LEAP will increase in value by roughly $5400 with a 100-point upward move in the SPX. By going through the option chain, you can quickly zero in on which combination of expiration month and strike price best fits into your trading plan.
I hadn't intended to spend this whole article talking about the SPX, but here I am, already running out of room. Let's see if I can cover the other majors in a more abbreviated manner.
Dow Jones 30 - As most of you are probably aware, you can't buy options on the DOW, but the DJX.X index is a capable proxy, as it is 1/100 the size of the actual DOW. When the DOW is at 9000 (I can dream, can't I?), then the DJX is at 90. Expiration months here are the same as for the SPX, with the notable exception that the series currently ends with DEC-2003 since the JUN-04 strikes have not been released. I actually prefer trading the LEAPS on the DJX to the SPX due to the fact that the contracts are more reasonably priced. A DEC-03 $80 strike is currently priced at $840, which is notable since that is practically an at the money option.
It isn't the absolute cost that I care about, but the ease with which you can tailor your trade size. Large traders with mid-6 figure accounts can quite easily pick up a dozen of the SPX LEAPS without exceeding a prudent threshold of having no more than 15% of their account at risk in a single trade. For the little guy, with a $50,000 account, one JUN-04 $925 Call is all that can be purchased without exceeding that 15% threshold. Playing in the SPX arena is too rich for this smaller trader, in my opinion, as it denies him the flexibility of entering the trade in stages, or taking partial profits as the trade works in his favor. On the other hand, this smaller trader could pick up 5 contracts for $3000, then another 5 for $4000 after the trade begins to work in his favor, for a total account allocation of $7000 (or 14%) in the trade. Then as the trade becomes profitable, you can sell 2 contracts here or 3 contracts there to lock in profits on the way up. I love that flexibility!
NASDAQ-100 - LEAPS aren't really available on the NDX, but as capable option traders, you all know that it isn't necessary, when we have the NASDAQ-100 Trust (the first of the Merrill Lynch HOLDRs), otherwise known as the QQQ. Strikes are nice and close together and we have strikes (that conform to the expiration month pattern of normal equities) out to JAN-04 currently with JAN-05 scheduled to arrive soon. For those that like to trade the QQQ and have a feel for the way it moves (and of course have a bullish outlook on Technology), this can be a great way to go. As a single data point, the JAN-04 $25 Call on the QQQ is currently trading for just $350. Going through the estimation exercise I outlined in the SPX section above shows that a move of about 6 points or 240 NDX points would yield a double on that LEAP.
If you prefer to focus your trading in the Technology realm, the QQQ LEAPS provide the same advantage as the DJX does, that of flexible position sizing.
Other HOLDRs - While I don't have space to go into any details here, there are LEAPS available on a few of the other Merrill Lynch HOLDRs, namely the SMH (Semiconductor HOLDR), BBH (Biotech HOLDR) and HHH (Internet HOLDR). If you're looking for a way to use LEAPS to trade the longer-term trend in any of these sectors, then these instruments definitely merit a closer look.
While our discussion here tonight has been necessarily brief, hopefully it has at least given you some food for thought and some ideas where to look for LEAP trades on the major indices, as well as enough knowledge to weigh the pros and cons of which index to focus on. I know there are likely many gaping holes in this article, which will generate plenty of questions. Send them my way and we'll explore them together in this forum as time permits on a week-by-week basis. In the meantime, I'll see if there isn't a way to squeeze a couple more of these indices or HOLDRs into our weekend visits in the LEAPS column.
Have a great week!